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1.1 FINANCE
Finance is the art and science of managing money or it may be defined as the provision of money
at the time when it is required. In today’s scenario it may be treated as the lifeblood of an
enterprise. Without adequate finance, no enterprise can possibly accomplish its objectives.
Finance
- Personal Finance
-Govt. Institutions
- Business Finance
- State Govt.
- Finance of Non-Profit
-Central Govt. Orgnisation
Or Financial Management is that area of general management which is concerned with the timely
procurement of adequate finance from various sources and its effective utilization for the
attainment of organizational objective.
Or Financial Management is concerned with the duties of the financial managers in the business
firm. Financial managers actively manage the financial affairs of business.
According Howard and Upton, “Financial Management is the application of planning and control
functions to the finance function”.
Financial management refers to the efficient and effective management of money (funds) in such a
manner as to accomplish the objectives of the organization.
(a) Investment Decisions are those which determine how resources in terms of funds available
are used for the project.
Determine the total volume of funds available.
Appraisal and selection of capital investment proposals.
Measurement of risk and uncertainty in the investment proposals.
Funds allocation
(b) Financing Decision The finance manager analyzes and selects the source of finance like
Equity or Debt.
Determining the Debt. Equity mix.
Raising of funds.
Dr. Himanshu Jain, PIET
Financial Management 3
(c) Dividend Decision concerned with the determination of amount of profits to be distributed
to the owners or to be retained with the firm.
Determination of dividend and retention policies of the firm.
Consideration of impact of levels of dividend
Consideration of possible requirement of funds.
The following two are often considered as the objectives of the financial management:
1. The maximization of the profit of the firm, and
2. The maximization of the shareholder wealth.
It is not clear in what sense the term profit has been used. It may be total profit before tax or after
tax or profitability rate. Rate of profitability may again be in relation to share capital, owner’s funds
total capital employed or sales.
o It ignores time value factor
All the monetary benefits and costs are considered in the absolute terms without adjusting for time
value.
o It is a narrow concept
It is a narrow concept which does not take into account social considerations and the interest of
other parities.
o It is a short term approach
It emphasizes the short-term profitability and short-term projects.
2.2.1 Inflation
Under inflationary conditions the value of money, expressed in terms of its purchasing power over
goods and services, declines.
To make the logical and meaningful comparisons between cash flows that result in different time
periods it is necessary to convert the sum of money to a same time period. There are two
techniques for doing this:
The time period for compounding the interest may be annual, semi-annual or any other regular
period of time.
𝐹𝑉 = 𝑃𝑉 (1 + 𝑖)𝑛
Example
If Mr. A invested Rs. 100 is invested at 10% compounding interest for 3 Years then calculate the
amount which Mr. A receive after 3 years.
FV = PV (1+ i)n
= 100 (1 + .10)3
= 133.1 Rs.
2.3.2 Present Value/ Discounting Technique
The process of calculating present values of cash flows. In this technique the reverse
compounding process is used to calculate the present value of future cash inflows.
𝐹𝑉
𝑃𝑉 =
(1 + 𝑖)𝑛
Where, FV = Amount at the end of 'n' period
PV = Principle amount at the beginning of the 'n' period
i = Rate of interest per payment period (in decimal)
n = Number payment periods
Example
If Mr. A expects to get Rs. 1000 after 3 year at the rate of 10%. Then calculate the amount he will
have to invest today.
PV = FV / (1+ i)n
= 1000 / (1 + .10)3
= 751.31 Rs.
Calculation of EMI
Example
Suppose you have borrowed a 3 year loan of Rs. 10000 at 9% from a bank to buy a motorcycle. If
your bank requires three equal end-of-year repayments, then the annual installment will be
PV = 𝐴 𝑥 𝑃𝑉𝐴𝐹
PV = Present Value
A = Annuity (EMI)
10000 = A x PVFA3,0.09
10000 = A x 2.531
A = 10000/2.531
= Rs. 3951
SOURCE OF FINANCE
Sources of
Finance
Retained Commercial
Equity Shares Debentures
Earnings Bank
Preference
Depreciation Trade Credit
Shares
Factoring
Advances
Commercial
Papers
Public
Deposits
Meaning of Share
A “share” represents a part of capital in a company. A share may be defined as one of the units
into which the share capital of a company has been divided.
The person holding the share is known as a shareholder.
Type of Share
3.2.1 Debentures
A debenture is a promissory note issued by a company as an evidence of a debt due from the
company.
It may with or without a charge on the assets of company. Debentures are generally issued by
private sector companies.
Or debt instrument that promises to pay a fixed annual sum as interest for specified period of time.
According to the Companies Act, the term debenture includes “debenture stock, bonds and any
other securities of a company whether constituting a charge of the assets of a company or not.”
Features of Debentures
Interest rate
Face value
Maturity
Claims on Income (have also priority over stockholder )
Claims on assets
Control
Types of Debentures
These debentures are given security on assets of the company. In case of default in the payment of
interest or principal amount, debenture holders can sell the assets in order to satisfy their claims.
Guaranteed Debentures
These are debentures or bonds on which the payment of interest and principal of is guaranteed by
third parties, generally, banks and govt., etc.
Collateral Debentures
A company may issue debentures in favour of a lender of money, generally the banks and financial
institutions, as collateral.
Note: Generally private sector companies issue debentures and public sector and financial
institutions issue bonds.
Debentures may be convertible into equity shares while bonds are not
3.3.3 Advances
Some business houses get advances from their customers and agents orders and this source is
source of finance for them. It is cheap source of finance.
3.3.6 Factoring
Factoring is a form of financing in which a business (client) sells its receivables to a third party
called factor (Financial institution/ financing company) at a discounted price.
3.4 INTERNAL FINANCING
Internal financing means arraigning funds from inside the company.
INTERNAL FINANCING
Source of Finance
Internal Finance
Financing an enterprise through its internal sources is known as internal financing. Such internal
resources comprise of earnings retained and depreciation.
Main Sources of Internal Financing
1. Retained earnings
2. Deprecation fund
Source of Finance
According to Time Period
Long-Term Source
Share, Debenture, Long-term loans, etc.
Short-Term Source
Advances from commercial banks, public deposits, advances from customers and trade
creditors.
According to Ownership
Own Capital
Share Capital, Retained Earnings and Surplus, etc.
Borrowed Capital
Debentures, public deposits and loans, etc.
According to Source of Generation
Internal Sources
Retained Earnings and depreciation funds, etc.
External Sources
Securities such as shares and debentures, loans, etc.
Meaning of Project
The term project refers to current outlay of funds in the expectation of a stream of benefits/
returns in the future.
Capital Budgeting
The Capital Budgeting is the process of evaluation and selecting long-term investment. It includes
heavy initial cash outflow and returns are expected over a long period.
Example New machine installation, new projects, or expansion of existing business.
Milton H. Spencer “Capital budgeting involves the planning of expenditures for assets the returns
from which will be realized in future time periods.”
Features or Significance
Long-term effects
Major effect on the profitability
Irreversible decision
Affect the capacity and strength to compete
b) Competitor’s strategy
c) Type of management
d) Govt. Policy
e) Cash flow
f) Return expected from investment
Key Words
Cash Flow This is the flow of cash into the firm or out of the firm.
Discount Rate The rate at which cash flows are discounted. This rate may be taken as
required rate of return on capital or cost of capital.
Payback Period
Accounting Rate of Return
Cash Flow Estimates Selection of Net Present Value
Appraisal Methods Profitability Index
Internal Rate of Return
Risk Return
Trade-off
Project Generation
Project Evaluation
Techniques of
Evaluation
Estimation of costs and benefits of a proposal 1. Payback
Period
2. Accounting
Estimation of the required rate of return Rate
of Return
3. Net Present
Using the capital budgeting decision criterion Value
4. Profitability
Index
5. Internal Rate
of
Return
Project Selection
Project Execution
(1)PAYBACK PERIOD it is defined as number of years required to recover the cost of the
project.
Illustration:- A project requires an outlay of Rs.50,000/- and annual cash inflow of Rs.12,500/-
for 7 Years. Calculate the Payback period for the project.
Advantages
Simplicity
Cost effective
Short-term effects
Risk shield
Liquidity
Disadvantages
It fails to account of the cash flows earned after the payback period.
It is not appropriate method of measuring the profitability of an project.
It ignore time value of money
It ignore cost of capital
Illustration
Bharat Electricals Ltd. Is thinking to buy a machine:
Machine A
Life 3 Years
Investment 200000
Income (After tax)
I year 60000
II Year 40000
III Year 20000
Calculate the average rate of return on investment and advice on the selection of the machine.
Project will be accepted if ARR is more than 25%.
Solution:
Mach. A
Average Income after tax= 60000+40000+20000
3
= 40000/-
Average Investment= ½ (Initial cost of Machine – Salvage value)+ Additional working capital+
Salvage value
= ½ (200000-0)+0+0
=100000/-
Average Rate of Return= 40000
100000 X100 = 40%
Advantages
Simplicity
Accounting profitability
Consider all the profits received during the life of the project.
Disadvantages
Cash flows ignored
Time value ignored
Ignore other factors affecting the profitability
No consideration for the amount invested in different projects
A rate of discount is used to calculate the present value of inflows and outflows.
It may be calculated as follows:
Dr. Himanshu Jain, PIET
Financial Management 20
Decision Rule
Accept the project when NPV is positive NPV > 0
Reject the project when NPV is negative NPV < 0
May accept the project when NPV is zero NPV = 0
WHEN CASH INFLOWS ARE EVEN
Illustration
Calculate NPV of an initial investment of Rs. 200000/- which periods a net cash inflow of 60000/-
every years. Assume required rate of return to be 8%. There is no scrape value.
=Cash inflows X PVAF6,8% - cash outflow
= (60000 x4.63)- 200000/-
= 77380/-
Thus NPV 77380/- is positive value the proposal should be accepted.
Year Cash
inflows
1 900/-
2 800/-
3 700/-
4 600/-
5 500/-
Find out the proposal should be accepted or not. If the discount rate or required rate of return is
10% P.A.
Year Cash Flows PVF @ 10% Present
Value
1 900 0.909 818
2 800 0.826 661
3 700 0.751 526
4 600 0.683 410
5 500 0.621 310
Total 2725
Or
Where
CO =Cash outflow at time 0
CF1 =Cash inflow at different
r = Rate of interest
SV = Salvage Value
WC = (1+r) n
Advantages
a) Consider time value
b) Measure of true profitability
c) Consider the entire life of project
d) Easier to calculate among the discounting techniques
Disadvantages
a) Difficult to determine discount rate
b) Difficult then PBP & ARR
c) Sensitive to discount rate
(2)Profitability Index
Profitability index is the ratio of present value of the inflows to the cash outflows of the investment.
PI measures the present value of return per rupee invested.
This is another time-adjusted capital budgeting technique. It is also benefits cost ratio. It is similar
to NVP technique.
PI= Present value of cash inflows
Present value of cash outflows
Decision Rule
When PI > accept the project
When PI < reject the project
When PI = Proposal may or may not accepted
Illustration:
A proposal having initial investment of Rs.2500/- Expected annual cash inflows.
Year Cash
inflows
1 900/-
2 800/-
3 700/-
4 600/-
5 500/-
Find out the proposal should be accepted or not. If the discount rate or required rate of
return is 10% P.A.
Year Cash Flows PVF @ 10% Present
Value
1 900 0.909 818
2 800 0.826 661
3 700 0.751 526
4 600 0.683 410
5 500 0.621 310
Total 2725
=2725
2500 = 1.09
Advantages
Simple and very easy to understand
Consider the time value of money
Consider the all cash flows during the life of the project.
Disadvantages
Not useful when small projects are to be compared with large project.
(3)INTERNAL RATE OF RETURN The IRR of a project is defined as the discount rate which
produces a zero NPV (NPV= 0). The IRR is the discount rate which will equate the present value of
cash outflows. It is also known as Marginal Rate of Return or Time Adjusted Rate of Return.
NPV (0)= CFo + CF1 + CF2 ---------CFn + SV+WC -CO
(1+ r)0 (1+ r)1 (1+ r)2 (1+ r)n (1+ r)n
Where
CO =Cash outflow at time 0
CF1 =Cash inflow at different
r = Rate of interest
SV = Salvage Value
WC = Working Capital
Advantages
No pre-determination of discounting rate
Consider the time value of money
It considers all cash flows.
It is a good measure of profitability.
Disadvantages
Dr. Himanshu Jain, PIET
Financial Management 23
Step-I
The payback period in the given case is 4 years. Now, search for a value nearest to 4 in the 6 th
year row of the PVAF table. The closest figures are given in rate 12% (4.111) and the rate 13%
(3.998) means that the IRR of the proposal is expected to lie between 12% & 13%.
Step-2
In order to make a precise estimate of the IRR, find out the NPV of the project for both these rates
as follow:
At 12%, NPV = (Rs. 25000/-x 4.111)- Rs. 100000/-
= 2775/-
At 13%, NPV = (Rs. 25000/-x 3.997)- Rs. 100000/-
IRR= L + A x (H-L)
(A-B)
=12.98% Ans
Where,
L= Lowest discount rate
H= Highest discount rate
A= NPV at L rate
B =NPV at H rate
Illustration
A project costing Rs. 160000/-
Estimate life 5 Yrs
Year Cash
1 Inflows
40000
2 60000
3 50000
4 50000
5 40000
Solution
Step-1 Find out weight average of cash inflows.
Dr. Himanshu Jain, PIET
Financial Management 24
= 160000
48667 = 3.288
Step-3
Now search the value 3.288 in 5 Yrs row of eh PVAF table. The closest figure is at 15% [3.352] &
16% [3.274]. This means IRR of the proposal is expected to be b/w 15% & 16%.
Step-4 Find out the NPV of the project on both of these rates
Year Cash Inflow PVF Present Value PVF (15%) Present
(16%) (16%) Value (15%)
1 40000 0.862 34480 0.870 34800
2 60000 0.743 44580 0.756 45360
3 50000 0.641 32050 0.658 32900
4 50000 0.552 27600 0.572 28600
5 40000 0.476 19040 0.497 19880
157750 161540
Step-5
IRR= L + A x (h-L) = 15 + 1540 x (16-15) = 15.40% Ans
A-B 1540-(2250)
Where,
L= Lowest discount rate
H= Highest discount rate
A= NPV at L rate
B =NPV at H rate
Risk and uncertainty are quite inherent in capital budgeting decision. Future is uncertain and
involves risk. The risk associated with a project may be defined as the variability that is likely to
occur in the future cash inflows from the project. All the capital evaluation techniques are based on
cash inflow related with a project. The cash flows are uncertain till its occurrence.
Types and source of Risk in capital budgeting
1. Project specific risk [management]
2. Competition risk
Payback period In PB method the preference goes to that project which have shorter time
period for recovery of investment. The shortening of the target payback period is based on
the assumption that larger the recovery period, more risky the proposal would be. But PB
method reduces only that risk which arises due to time period and thus allows for other
risks.
Risk adjusted Discount Rate The amount of risk in the project is inbuilt in the discount
rate to make the present value calculation. The discount rate would be high when the risk is
high and the discount rate is comparatively lower when the risk is low.
Dr. Himanshu Jain, PIET
Financial Management 26
Certainty Equivalents The CE approach attempts at adjusting the future cash flows
instead of adjusting the future cash flows instead of adjusting the discount rates. The
expected future cash flows which are taken as risky and uncertain are converted into
certainty cash flows.
For exp. Sensitivity analysis provides different cash flow estimates under three assumption.
(i) the worst (i.e. the most pessimistic), (ii) the expected (i.e. the most likely), and (iii)
the best (i.e. the most optimistic) outcomes associated with the project.
Statistical Technique
Decision-tree Approach is a pictorial representation in tree form which indicates the
magnitude, probability and inter-relationship of all possible outcomes. Every possible
outcome is weighted in probabilistic terms and then evaluated. The DT approach is
especially useful for situations in which decision at one point of time also affect the decisions
of the firm at some later date.
Probability distribution
The NPV method recognizes the importance of market rate of interest or cost capital
and IIR method does not consider the market rate of interest and seeks to determine the
maximum rate of interest at which funds invested in any project could be repaid with the
earnings generated by the project.
The basic presumption of NPV method is that intermediate cash inflows are reinvested
at the cut off rate whereas, in the case of IRR method intermediate cash flows are
presumed to be reinvested at the internal rate of return
The results shown by NPV method are similar to that of IRR method under certain
situations, whereas, the two give contradictory results under some other circumstances.
Similarities
Both methods would show similar results in terms of accept or reject decisions in the following
cases:
Independent investment proposals which do not compete with one another and which may
be either accepted or rejected on the basis of a minimum required rate of return.
Conventional investment proposals which involve cash outflows in the initial period followed
by a series of cash inflows.
The reason for similarity of results in the above cases lies in the basis of decision making in the two
methods. Under NPV method, a proposal is accepted if its net present value is positive, whereas,
under IRR method it is accepted if the internal rate of return is higher than the cut off rate. The
projects which have positive net present value, obviously, also have an internal rate of return
higher than the required rate of return.
Problem of difference in the cash flow patterns or timings of the various proposals, and
In such cases, while choosing among mutually exclusive projects, one should always select the
project giving the largest positive net present value using appropriate cost of capital or
predetermined cut off rate. The reason for the same lies in the fact that the objective of a firm is to
maximize shareholder’s wealth and the project with the largest NPV has most beneficial effect on
share prices and shareholder’s wealth. Thus, the NPV methods are more reliable as compared to
the IRR method in ranking the mutually exclusive projects. In fact NPV is the best operational
criterion for ranking mutually exclusive investment proposals.
A series of inward and outward cash flows over time in which there is more than one change in the
cash flow direction. This cdiviontrasts with a conventional cash flow, where there is only one
change in cash flow direction. In terms of mathematical notation - where the - sign represents an
outflow and + denotes an inflow - an unconventional cash flow would appear as -, +, +, +, -, + or
alternatively +, -, -, +, -.
IRR method does not tell about how much return the firm is going to earn from a project whereas
NPV tells about the exact amount of return from a project.
COST OF CAPITAL
1. Cost of debt
Usually rate of interest payable on debentures is treated as its cost but it is not correct. The
floatation cost should be considered.
a. Perpetual or irredeemable Debt
Cd = i / NP x 100
Where
i= Amount of annual interest
NP= Net Proceeds
Illustration
A company issues 10% debentures of Rs. 1000/- at par and expenses of issue are 4%.
Sol. 1000 – 40 = 960
Cd = 100/ 960 x 100
= 10.42%
b. Redeemable Debt
MV-NP
I+
n
Cd=
MV+NP
2
Where,
i= annual interest payment
MV= Maturity value
NP= Net proceeds
n= number of years to maturity
Illustration
Dr. Himanshu Jain, PIET
Financial Management 29
PD
Cp= X 100
NP
Where,
PD= preference dividend amount per share
NP= net proceeds per share
MV-NP
PD+
n
Cp= x 100
MV+NP
2
Where,
PD= amount of annual preference dividend
MV= Maturity value
NP= Net proceeds
n= number of years to maturity
Cp (before tax) = after tax cost / (1- tax rate)
3. Cost of equity share capital
a. Dividend yield method
DPS
Ce= X 100
MP
Where,
DPS= Current cash dividend per share
MP= Market price per share
EPS
Ce= X 100
MP
Where,
EPS= Earning per share
MP= Market price per share
c. Dividend yield + growth in dividend method
DPS
Ce= X 100 +G
MP
Where,
DPS= Current cash dividend per share
MP= Market price per share
G= Growth rate in dividend
Ce (before tax) = after tax cost / (1- tax rate)
4. Cost of retained
Many people feel that such retained earnings are absolutely cost free. This is not the correct
approach because the amount retained by company, if it had been distributed among the
shareholders by way of dividend, would have given them some earning. The company has deprived
the shareholders of these earnings by retaining a part of profit with it. Thus, the cost of retained
earning is the earning forgone by the shareholders. In other words, the opportunity cost of
retained earnings may be taken as the cost of retained earnings.
This can be understood in the following manner. Suppose the earnings are not retained by the
company and passed on to the shareholders, are invested by the shareholders in the new equity
shares of the same company, the expectation of the shareholders from the new equity shares
would be taken as the opportunity cost of the retained earnings
Adjustment Required
Income Tax Adjustment
The cost of retained earnings after making adjustment for income tax and brokerage cost payable
cost payable by the shareholders can be determined according to the following formula:
Cr = Ce (1-T) (1- B)
Where,
Cr = cost of retained earnings
Ce = cost of equity
T = Tax rate
B = Brokerage cost
Cr (before tax) = after tax cost / (1- tax rate)
Weighted Average Cost of capital
A company finances its projects by different sources, although the specific cost of each sources of
finance is different. Some are cheaper and some are dearer. There are two objectives of this
policy- firstly, to balance the capital structure and secondly to increase the return of equity
shareholders. These objectives can be achieved only when firm’s average cost of financing is lower
than its return on investment. This requires the computation of overall or average cost of capital.
The average can be a simple average or weighted average. However, weighted average is more
reasonable and appropriate as it gives due emphasis to different sources of capital in the capital
structure of a firm.
Process of Computation of Weighted Average Cost of Capital
(a) The computation of specific costs of various sources. It has already been explained in the
preceding pages in this chapter.
(c) Each specific cost is multiplied by the corresponding weight and in this way weighted cost of
each source is determined.
(d) Finally, weighted cost of all sources of capital as calculated in (3) are added together to get
an overall weighted average cost of capital.
Market Value
In this, market value of invested capital funds of each type of security is calculated on the basis of
their prevailing market values and proportion of each type of security to the total of market values
of all securities is used as weight.
COST OF CAPITAL
Capital Asset Pricing Model or CAPM Approach
This model takes Risk-free rate of return (Rf) as the benchmark and to that is added the risk premium
required to cover the risk for investing in a specified firm. Risk premium is measured by beta (β). If the
beta of the firm is also 1, it means that the returns of the firm will change by the same percentage as the
returns of the market. On the other hand, if the firm has a beta of 2, its returns change as much as twice
of the market of the market returns either way. Beta may be positive or negative.
The Cost of Equity, according to CAPM, can be calculated as below:
Ce = Rf + Bi (Rm - Rf)
Where, Ce = Cost of Equity
Rf = Risk- Free Rate of Return
Rm = Market Return
β f = Beta co-efficient
In capital budgeting, corporate accountants and finance analysts often use the capital asset pricing
model, or CAPM, to estimate the cost of shareholder equity. The CAPM formula requires only three
pieces of information: the rate of return for the general market, the beta value of the stock in question
and the risk-free rate.
Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)
The rate of return refers to the returns generated by the market in which the company's stock is traded. If
company CBW trades on the Nasdaq and the Nasdaq has a return rate of 12%, this is the rate used in the
CAPM formula to determine the cost of CBW's equity financing. The beta of the stock refers to the risk
level of the individual security relative to the wider marker. A beta value of 1 indicates the stock moves
Dr. Himanshu Jain, PIET
Financial Management 32
in tandem with the market. If the Nasdaq gains 5%, so does the individual security. A higher beta
indicates a more volatile stock and a lower beta reflects greater stability. The risk-free rate is generally
defined as the rate of return on short-term U.S. Treasury bills, or T-bills, because the value of this type
of security is extremely stable and return is backed by the U.S. government.
Numerous online calculators can determine the CAPM cost of equity, but calculating the formula by
hand or in Microsoft Excel is simple. Assume CBW trades on the Nasdaq, which has a rate of return of
9%. The company's stock is slightly more volatile than the market, with a beta of 1.2. The risk-free rate
based on the three-month T-bill is 4.5%. Based on this information, the cost of the company's equity
financing is 4.5 + 1.2 * (9 - 4.5), or 9.9%.
The cost of equity is an integral part of the weighted average cost of capital, or WACC, which is widely
used to determine the total anticipated cost of all capital under different financing plans.
CAPITAL STRUCTURE
Capital structure refers to the mix of long-term source of funds, such as debentures, long-term debts, preference
share capital, equity share capital and reserve & surplus (i.e. retained earnings)
Debenture 3,00,000
Company Size
Cost of Capital
Investor’s Attitude
Legal Provision
Marketability
Tax Consideration
Nature of Business
Stability of earnings
Amount of funds
Capital structure theories seek to explain the relationship between capital structure decision and the market value
of the firm.
Different views have been expressed on the relationship between capital structure, cost of capital and value of the
firm. Some says that capital structure decisions have affect on the value of the firm and some says that don’t
have. These different views on such relationship, known as theories of capital structure.
Assumptions
1) That there are only two sources of funds i.e., the equity and the debt.
2) That the total assets of the firm are given and there would be no change in the investment decisions of
the firm.
3) That the firm has a policy of distribution the entire profits among the shareholders means there is no
retained earnings.
4) The operating profits of the firm are given and are not expected to grow.
5) The business risk complexion of the firm is given and is constant and is not affected by the financing mix.
6) That there is no corporate or personal tax.
Net Income Approach
This approach has been suggested by Durand. According to this approach capital structure affect the cost of
capital and value of the firm.
In other words, a change in the debt-equity mix will lead to a corresponding change in the overall cost of capital
as well as the total value of the firm.
Justification:
This approach says that change in financing mix of a firm will lead to change in overall cost of capital of the firm
resulting in the change in the value of the firm. As cost of debt is less than cost of equity the increasing use of
cheaper debt will reduce the overall cost of capital. This will increase the return to equity share holder. And this
will increase the value of the firm. And Vice-versa.
Additional Assumption
1. That the total capital requirement of the firm is given and remains constant.
2. That cost of debt is less than cost of equity.
3. Both cost of debt and cost of equity remain constant.
4. Investor’s perception about the risk doesn’t change with the change in Debt- Equity Mix.
Assumption
1. The market capitalizes the value of the firm as a whole and, therefore, the split between debt and equity is
not relevant.
2. The overall cost of capital of the firm is constant and depends upon the business risk which also is
assumed to be unchanged.
3. That there is no tax, and
4. The use of more and more debt in the capital structure increases the risk of the shareholders and thus
results in the increase in the cost of equity capital. The increase in is such as to completely off set the
benefits of employing cheaper debt.
V= value of firm
ko= overall cost of capital
EBIT= Earnings before interest and tax
Traditional Approach
The Traditional approach is a compromise between the two extremes of Net Income approach and Net Operating
Income approach. It is also known as ‘Intermediate Approach’.
According to this approach, the value of the firm can be increased or cost of capital can be decreased by
increasing debt content of capital structure as debt is a cheaper source of funds than equity. Beyond a particular
point, the cost of equity increases because increase increasing proportion of debt increases the financial risk of
equity shareholders. The advantage of cheaper debt is thus offset by increased cost of equity.
Modigiliani-Millar Approach
MM approach is similar to the Net Operating Income Approach in its conclusions. In other words, according to this
approach, the value of a firm is independent of its capital structure.
However, there is one basic difference between the two. The NOI approach is purely conceptual and does not
provide operational justification for irrelevance of the capital structure in the valuation of the firm. On the hand,
MM approach provides operational justification for irrelevance.
Assumptions
1. Perfect capital Market
a. The investors are free to buy and sell securities.
b. The investors can borrow on the same terms on which the firm can borrow.
c. The investors are well informed and they behave rationally.
d. There are no transaction costs.
2. Homogeneous Risk Class
The firms can be classified into homogeneous risk classes and all firms within the same class will
have the same degree of business risk.
3. Expectations about the net operating income
All investors have the same expectation of a firm’s net operating income (EBIT) with which to evaluate
the value of any firm
4. No taxes
There are no retained earnings(This assumption was relaxed later.)
5. Full Pay-out
Means there is no retained earnings
Justification
The term ‘Arbitrage’ refers to an act of buying an asset or security in one market having lower process and selling
it in another market.
The consequence of such action similar in all respects except in their capital structures cannot for long remain
different in different market.
Limitation
1. Rate of interest are not same for individuals and the firms.
2. Transaction costs involved.
3. Institutional Restrictions (The switching option from one firm to another firm is not available to all
investors.)
4. Corporate Tax frustrate MM hypothesis.
5. Availability of complete information.
Optimum capital structure is the capital structure at which the weighted average cost of capital is
minimum and there by maximum value of the firm.
In the words of Solomon Ezra “Optimum capital structure can be define as that mix of debt and equity
which will maximize the firm’s market value of a company and minimize its cost of capital.”
Objectives of Optimum Capital Structure
Minimization of capital cost
Minimization of Risk
Maximization of Return
Preservation of control
Considerations
The capital structure should be flexible.
The company should involve minimum possible risk of loss of control.
If the return on investment is higher than the fixed cost of funds (i.e., interest and preference
dividend), the company should prefer to raise funds having a fixed cost to increase the return of
equity shareholders. This known as taking the advantage of favorable financial leverage.
The company should take advantage of the leverage offered by high corporate taxes. The higher
cost of equity financing can be avoided by using debt as a source of finance as interest on dev is
an allowable deduction in computation of taxable income.
The company should avoid a perceived high risk capital structure because excessive debt
financing reduces market price of equity shares. Hence, the use of debt should be within the
capacity of the company. The company should be in a position to meet its obligations in paying
the loan and interest charges as and when due.
Operating cycle is the time span the firm requires in the purchase of raw materials, conversion of
raw materials into work in progress and finished goods, conversion of finished goods into sales and
in collecting cash from debtors. Larger the time span of operating cycle, larger the investment in
current assets.
60
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡 = 4800000 𝑋 + 75000
360
= 875000/-
For proper computation of working capital under this method, a detailed analysis is made for
following individual component of working capital:
(i) Stock of raw material
(ii) Stock of work-in-process
(iii) Stock of finished goods
(iv)Investment in debtors/ receivables
(v) Cash & bank balance
(vi)Prepaid expenses
(vii) Trade creditors
(viii) Creditors for wages and other expenses
(ix)Advanced received
Dr. Himanshu Jain, PIET
Financial Management 38
collection centre and its actual depositing in the local bank account. Lock-box system has
been devised to eliminate delay on account of this time gap. According to this system, the
firm hires a post-office box and instructs its customers to mail their remittances to the box.
Temporary Working Capital : Any amount over and above the permanent level of working capital is
called temporary working capital or fluctuating working capital. Due to seasonal changes, level of
business activities is higher than the normal time, therefore, additional working capital will be required
along with the permanent working capital. It is so because during peak season, demand rises and more
stock is to be maintained to meet the demand. Similarly the amount of debtor increases due to excessive
sales. Additional working capital thus needed is known temporary working capital because once the
season is over, the additional demand will be no more. This need for temporary working capital should
be met from short term sources of finance. Both types of working capital is necessary to run the business
smoothly.
Above diagram shows that permanent working capital remains the same through out the year. While
temporary working capital is fluctuating in accordance with the seasonal demand.
However in case of expanding concern, the need for working capital may not be constant and it would
be increasing. Then the permanent working capital line may not be horizontal and it will go on rising as
illustrated in the following diagram.
1. Nature of Business : Requirement of working capital are largely influenced by the nature of the
business. In case of trading unit requirement of working capital is high because these unit sale
and purchase of goods. For instance public utilities such as Railways, Transport water, electricity
etc. have a very limited need of working capital because they have to invest large amount in
fixed assets. They have to maintain a lower level of working capital for immediate payment for
their services. Financial enterprise have to invest less amount in fixed assets and large amount in
working capital.
2. Size of Business : Larger the size of business, greater would be the need for working capital.
The size of business may be measured in terms of scale of its operation.
3. Growth and Expansion : As a business enterprises grows, it is logical to expect that a larger
amount of working capital will be required. Growth industries required more working capital
than these that are static.
4. Production Cycle : It means time gap between the purchase of raw-material and its conversion
into finished goods larger the production cycle, larger will be the need for working capital
because the funds will be tied up for a longer period in work in progression if the production
cycle is small the need for working capital will also be small.
5. Business Fluctuations : It may be in the direction of boom and depression. During boom period
the firm will have to operate at full capacity to meet the increased demand which in turn, leads to
increase the level of inventories and book debts. Hence the need of working capital in boom
conditions is bound to increase and in case of depression period the requirement of working
capital is low.
6. Production Policy : The demand for certain products is seasonal. Two types of production
policy may be adopted for such products. Firstly, the goods may be produced in the month of
demand and secondly the goods may be produced throughout the year. If the second alternative
is adopted, the stock of finished goods will accumulate up to season of demand which requires
on increasing amount of working capital that remains tied up in the stock of finished goods for
some months.
7. Credit Policy Relating to Sale : If a firm adopt liberal credit policy in respect of sales, the
amount tied up in debtors will also be higher. Obviously higher book debts mean more working
capital vice versa.
8. Credit Policy Relating to Purchase : If a firm purchase more goods on credit, the requirement
for working capital will be less. In the other words, if liberal credit terms are available from the
suppliers of the goods the requirement for working capital will be reduce.
9. Availability of Raw Material : If the raw material is easily available on a continuous basis,
there will be no need to keep a large inventory of such material and hence the requirement of
working capital will be less. On the other hand, if the supply of raw-material is irregular the firm
will be compelled to keep on excessive inventory of such material which will result in high level
of working capital.
10. Availability of Credit from Books : If a firm can get easy bank credit facility in case of need, it
will operate with less working capital on the other hand, if such facility is not available, it will
have to keep a large amount of working capital.
11. Other Factors :
a. Volume of Profit.
b. Dividend Policy
c. Depreciation Policy
d. Price level Changes
e. Efficiency of Management.
In this technique manager wants to reduce the cost of carrying and cost of ordering.
Manager try to find out the quantity which should be purchased in a lot.
Which result reduction in the cost of the inventory.
√2xRxCp/ Ch
Where R = Annual Requirement
Dr. Himanshu Jain, PIET
Financial Management 42
Assumptions
Limitations
It assumes that the firm makes an exact estimate of its future requirements. It is difficult to
predict that exact usage.
The model assumes a very unrealistic issue it state that there is no time gap between order of an
item and its future supply.
The EOQ does not consider the order of units in fractions. Goods can be ordered only in multiple
figures.
The EOQ model assumes that cost order does not change. This means that they do not consider
the economics of scale or discounts that are offered for bulk purchases.
The Miller-Orr model increases its practicability by incorporating an assumption that cash balances
randomly fluctuate and therefore are uncertain. The formula in determining the desired cash level is as
follows:
Baumol’s Model
Most firms try to minimise the sum of the cost of holding cash and the cost of converting marketable
securities to cash.
Baumol’s cash management model helps in determining a firm’s optimum cash balance under certainty.
As per the model, cash and inventory management problems are one and the same.
There are certain assumptions that are made in the model. They are as follows:
1. The firm is able to forecast its cash requirements with certainty and receive a specific amount at
regular intervals.
2. The firm’s cash payments occur uniformly over a period of time i.e. a steady rate of cash outflows.
3. The opportunity cost of holding cash is known and does not change over time. Cash holdings incur an
opportunity cost in the form of opportunity foregone.
4. The firm will incur the same transaction cost whenever it converts securities to cash. Each transaction
incurs a fixed and variable cost.
For example, let us assume that the firm sells securities and starts with a cash balance of C rupees. When
the firm spends cash, its cash balance starts decreasing and reaches zero. The firm again gets back its
money by selling marketable securities. As the cash balance decreases gradually, the average cash
balance will be: C/2.
The optimum cash balance, C* is obtained when the total cost is minimum.
Optimum cash balance (C*) = Ö2cT/k
Where, C* is the optimum cash balance.
T is the total cash needed during the year.
k is the opportunity cost of holding cash balances.
With the increase in the cost per transaction and total funds required, the optimum cash balance will
increase. However, with an increase in the opportunity cost, it will decrease.
Limitations of the Baumol model:
1. It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.
DIVIDEND DECISION
Dividends are payments made by a company to its shareholder from its earnings. When a company earns
a profit , that money can be put to two uses:
It can either be it can be paid to the shareholders as a Dividend or
Can be re-invested in the business called Retained Earnings or plough back of profits.
Assumptions
1. Constant return and cost of capital
The Walter’s model assumes that the firm’s rate of return r, and its cost of capital, K, is constant
2. Internal financing
All financing is done through the retained earnings; that is, external sources of funds like debt or new
equity capital are not used.
3. 100% payout or retention
All earnings are either distributed as dividends or reinvested internally immediately.
4. Constant earnings per share and constant dividends per share
There is no change in the key variables, namely, beginning earnings per share E and dividends per share
D. the values of E and D may be changed in the model to determine results, but any given value of E and
D are assumed to remain constant forever in determining a given value.
5. Infinite time
The firm has perpetual (very long) or infinite life.
2. GORDON’S MODEL
Gordon’s Model is another theory which contends that dividend policy is relevant for the value of the
firm. Gordon’s argument is a twofold assumption:
(i) Investors are risk averse, and
(ii) The investors put a premium on a certain return and on the other hand they discount
uncertain returns.
Investors are rational in their approach and they want to avoid risk. There are two possible actions
for the firm:
(a) It can distribute the current dividends, or
(b) Can retain its earnings
Out of both these actions of the firm the investor would always prefer the first, i.e. distribution of the
current dividends rather than its retention by the firm for distribution of dividend in the future.
This is because of the reason that the future dividend is uncertain, both with respect to the amount as
well as the timing.
Thus, the investors would discount future dividends, that is, they would place less importance on it as
compared to current dividend. They considered being risky option. Therefore, if the earnings are
retained, the market price would be adversely affected.
This is also described as a bird-in-the-hand approach. That a bird in hand is better than two in the
bush, i.e., what is available at present is preferable to what may be available in the future.
Investor would be inclined to pay a higher price for shares on which current dividends are pain and they
would discount the value of shares of a firm which postpone dividend.
(1 − 𝑏)
𝑃=𝐸
𝐾𝑒 − 𝑏𝑟
Where, P = Market Price per Share
E = Earnings per Share
r = Firm’s rate of return
b = Retention ration or percentage of earnings retained
Dr. Himanshu Jain, PIET
Financial Management 48
br = g = Growth Rate
(1 - b) = D/P ratio
Ke = Cost of Capital/ Capitalization rate
Assumptions:
1. Perfect Capital Market
The firm operates in perfect capital markets where investors behave rationally, information is freely
available to all, there are no transaction and flotation costs and no investor is large enough to influence
the market price of securities.
2. No Taxes
There are no taxes.
3. Fixed Investment Policy
The firm has a fixed investment policy which does not change. It means that the risk complexion of the
firm will not change due to new investments out of the retained earnings.
4. Certainty of Earnings
There is prefect certainty as to future profits of the firm. Investors are able to forecast future share prices
and dividends with certainty. This assumption is dropped by MM later.
Logic behind MM Theory
MM claim that since the value of the firm depends upon its earnings and is not affected by the dividend
decision, shareholders are also indifferent between dividend and retention of earnings.
If the firm selects the first alternative, it will not pay any dividends and will retain the earnings to
finance investment programme. If a shareholder wants cash, he can create a ‘home-made dividend’ by
selling a part of his shares at market price. The shareholder will have less number of shares. He has
exchanged a part of his holding in the firm to a new shareholder for cash. Neither the firm nor the
shareholder loses or gains due to this transaction. The value of the firm remains the same due to
exchange of shares among shareholders.
If the firm selects alternative, if will pay dividends to the shareholders. Shareholders get cash in their
hands, but the firm’s assets reduce because of reduction in its cash balance. As a result, present value per
share will decline. Thus what is gained by the investors in the form of dividends will be neutralized
completely by a decline in the value of their shares. hence, he will be indifferent between dividend and
retention of earnings which implies that the dividend decision is irrelevant. Firm also will not be
affected by payment of dividends because the effect of dividend payment will be exactly offset by the
effect of raising additional share capital.
Criticism of MM Approach
Because of unrealistic assumptions the MM approach is alleged to lack practical relevance.
(a) Tax Effect
(b) Flotation Cost
(c) Transaction Cost
(d) Institutional Restrictions
(e) Near V/s Distant Dividend
(f) Informational Utility of Dividends
(g) Sales of New Shares at Lower Prices